How a Falling Interest Rate Cycle Affects Your Debt Portfolio   Jun 18, 2012

There are some things that can confuse even seasoned equity investors. One of these things is the link between debt funds and the interest rate cycle.

Let’s start at the beginning.

First, what is a debt fund?

A debt fund is nothing but a pool of investments (also known as a mutual fund) in which the core portfolio comprises fixed income investments. These would be a mix of short, medium or long term bonds, money market instruments, securitized products and floating rate debt.

Bonds (also called fixed income securities) are used by a variety of entities such as corporates, municipalities and even the Government, to finance activities. When you buy a bond, you are effectively lending money to this entity that borrows your funds for a fixed time period and pays you a pre-decided rate of interest at regular intervals, also pre-decided. This interest is called a Coupon.

Bonds are also traded in the secondary market before they reach maturity, and each bond has a price that fluctuates depending on market factors.

Given that bond prices fluctuate, it is unlikely that you would ever buy a bond on the secondary market "at par", or at its exact face value. You would either buy below par i.e. at a discount, or above par i.e. at a premium.

Now that we know what coupon, price, and discount and premium are, what is yield (to maturity)?

Yield to Maturity (YTM) represents the total return you can expect to earn if you buy a bond at a certain price and hold it till it matures, earning all the coupons (or regular interest payouts) on the way too.

A simpler version of this is just Current Yield. If you buy a bond "at par", the yield is simply the Coupon. But if you by a bond where the price is fluctuating, your yield will also fluctuate depending on how expensive (or not) your bond is.
This Yield is equal to nothing but Coupon divided by Price.

So current yield =

From the equation above you will see that if price goes up, yield will come down, and conversely, if prices fall, your yield increases. So you can see that the relation between yields and prices is an inverse one.

Now that you’ve understood the relation between yields and prices, in which situation would you want high yields and in which situation would you want high prices?

You would want high yields (i.e. low prices) when you are looking to buy a bond. The adage Buy Low, Sell High applies here too. Once you have already bought the bond and become a bondholder, you want high prices so that you can sell at maximum gain.

So knowing this, when is a good time to become a bondholder?
When you know that yields are going to go down, going forward, and therefore prices of existing bonds are going to go up which will enable you, the bondholder, to make maximum gain when your bond matures, or when you sell.

This is what’s happening in our economy at the moment...

We are currently in a falling interest rate cycle.
When interest rates in the economy (the repo and reverse repo rate) begin to fall, new bonds will offer interest (coupon, to the bondholder) in line with the new, lower rates of interest. This means that their coupon will be lower, so their yield will be lower than the coupon and yield of existing bonds. Older bonds that were issued in times of higher interest rates, would be offering higher coupons and therefore comparatively higher yields. So these existing bonds therefore become comparatively more attractive than newer bonds. People are therefore willing to pay a premium to own these bonds. So when yields fall, prices of existing bonds go up. It's simply a question of demand and supply.

And that’s when debt funds make money, when the bonds in their portfolios start to command higher prices, in times of falling interest rates.

How does this affect your finances? Should you be adding to your debt portfolio currently?

To answer the second question first, yes you should be adding to your debt exposure if you have a lower risk appetite, a shorter time horizon (up to 3 years) and want to increase your debt portfolio exposure, to balance your equity portfolio you should invest in short and medium income funds. Keep your liquidity requirements in mind and also have an estimate of what post-tax return you can expect (debt funds long term gains are taxed at 10% without indexation or 20% with indexation).

Debt funds are a very sound investment in times of falling interest rates. When we witnessed the credit crunch of 2008, and governments across the globe including ours started cutting interest rates in an effort to boost liquidity like it was going out of style (therefore, dropping yields drastically) debt funds and gold prices went up almost 30%, while equity steadily crashed. The RBI decided against a repo rate cut today (mid-term Monetary Policy Review) which means chances of a rate cut in July (quarterly Monetary Policy Review) go up. Keeping in mind also that the monsoon thus far was delayed and has been weak, we can expect an increase in core inflation. By July, the RBI will have more data for a longer period, on the monsoon, the global markets and our own economy growth. If we see a rate cut, debt funds will be positively impacted.

Coming to the first question, remember, debt funds are great investment avenues to help you meet your short term life goals and also to contribute towards a corpus for your longer term life goals. So if you are looking to build a debt portfolio, now is a great time to do it.

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Jan 07, 2015

Yours is a clever way of thinking about it.